How Dividends Can Cost You Money

Traders work on the floor before the closing bell of the Dow Jones at the New York Stock Exchange, March 24, 2017 in New York. / AFP PHOTO / Bryan R. Smith (Photo credit should read BRYAN R. SMITH/AFP/Getty Images)

Given that the human lifespan has risen globally, first in wealthy nations like the United States and Japan, and now rising almost everywhere, people are worrying about how to finance the consumption they will need in retirement. As one solution, many people seek to fund their retirement by matching their consumption needs with income generated by their retirement assets, through periodic payments like interest, bond coupons or dividends. While it is possible to consume out of the principal, many investors seem reluctant to do so, and instead choose assets that will let them consume only out of income streams. With interest rates coming out of a period of historic lows, bonds are losing value for investors and those investors seeking to meet their retirement-savings goals are looking ever more towards reliable investment sources. As such, dividend-paying stocks are looking more and more favorable given their reputation as a reliable low-risk way to generate a stream of payments. But are investors who view dividends as an income stream making a mistake?

Historically, retirees have poured into dividend-paying stocks, perceiving a stock’s dividend as an income source akin to a bond coupon that gives reliable returns over time. In a classic paper by the economists Merton Miller and Franco Modigliani, the duo famously showed that investors ought to be indifferent between $1 in the form of a dividend and receiving $1 by selling shares. This is because when a stock pays a dividend of $1, the share price drops by $1 leaving an investor with no more value than they had before the dividend was paid. In other words, in the Miller and Modigliani framework, the distinction between “principal” and “income” is illusory. Unless there are frictions like taxes or transaction costs, equity investors can convert principal into income or vice versa according to their preferences, by either selling some stock or reinvesting dividends. This holds regardless of what the payout policy of the firm is.

But in fact, a large number of investors express a strong preference for dividend-paying stocks, suggesting that people don’t really understand that dividend pay-outs are offset by falls in the stock price. Does the lay investor truly understand how dividends operate in practice?

In a famous paper, Hersh Shefrin and Meir Statman, examined how investors treated dividends. The duo asked people to consider two cases:

You take $600 received as dividends and use it to buy a television set.

You sell $600 worth of stock and use it to buy a television set.

A rational investor would realize that both scenarios are identical, but surprisingly Shefrin and Statman found that investors did not treat them the same, expressing significantly more regret for the purchase in case 2. This simple hypothetical suggests that investors do not view money from dividends and that from a stock sale as the same.

In recent work, Professors Samuel Hartzmark from Chicago Booth School of Business and David Solomon from the Marshall School of Business at USC, suggest that investors continue to have it backwards when it comes to understanding dividends. In practice, many individual investors, mutual funds and institutions treat dividends and capital gains as separate attributes – not really understanding that dividends come at the expense of price decreases. In other words, if an investor buys two stocks at $5, they view the stocks differently if one goes to a price of $7 with no dividend and one goes to a price of $6 with a dollar dividend. Income seeking investors prefer the latter, even though they receive the same amount of total value. Hartzmark and Solomon call this mistake the free dividend fallacy – the notion that investors wrongly view that they have received free money from a dividend by not realizing that the price dropped to offset the dividend amount.

Larry Swedroe, a principal and the director of research for Buckingham Strategic Wealth, frames the free dividend fallacy nicely – “What [investors] fail to realize is that a cash dividend is the perfect substitute for the sale of an equal amount of stock whether the market is up or down, or whether the stock is sold at a gain or a loss. It makes absolutely no difference. It’s just a matter of how the problem is framed. It’s form over substance.”

Consistent with this behavior, Hartzmark and Solomon show that individuals, mutual funds and institutions are all less likely to sell stocks that pay more dividends, holding them for longer than other stocks in order to receive a dividend payout. Interestingly too, Hartzmark and Solomon find that the demand for dividends falls when stock returns tend to be higher – suggesting once again that investors don’t take into account that dividends and capital gains both contribute to total returns. During the tech boom, investors all but forgot about dividends, focusing aggressively on price appreciation alone. The free-dividends fallacy also leads investors to rarely reinvest in those same stocks that issue the dividends. All of this supports what Hartzmark and Solomon term the “dividend disconnect” – mistakenly considering the increase in price and the level of the dividend as separate desirable attributes.

Many investors have come to rely on dividend payments as a safe bet – especially in times of volatile markets or when bonds are paying at low rates. What this means is that lots of investors want to receive dividends at the same time, and in doing so they push up the price of dividend paying stocks. Thus investors who are buying dividends for the extra cash, are experiencing lower total returns because they are buying dividend-paying stocks when they are over-priced. In fact, Hartzmark and Solomon finds that investors buying dividend-paying stocks during times of high demand earn about 2 to 4 percent less per year.

The bottom line is that dividends and capital gains are profit sources that need to be combined when calculating value as dividends reduce the price of stock. Investors seem to consider dividends as free money. The dividend payout doesn’t make one better or worse off. In times when markets are volatile the dividend payout is not a safe bet by any definition, and the fact that investors want that payout and perceive it as safe is evidence that most investors simply don’t understand the tradeoff with the price. Investors often treat the two in separate mental accounts, leading to significant lower returns – something that needs more discussion in the financial press.

As for how to help investors protect themselves against the free dividends fallacy? The first step to overcoming any bias is to understand that it exists. So the next time you consider a dividend paying stock, make sure you are investing in it to receive the total return, not simply focusing on the dividend payout which may turn out to cost you in the end.